Cost-Volume-Profit Analysis
Fixed costs and variable costs
Importance of relevant range
The relevant range of the activity index
is the range over which a company expects to
operate during a year. Companies usually
operate at 40-80% capacity.
Mixed costs
Sometimes called semivariable costs.
Mixed costs change in total, but not
proportionately with changes in the activity
level.
Mixed costs must be classified into their
fixed and variable elements. Firms usually
ascertain variable and fixed costs on an
aggregate basis at the end of a time period.
CVP assumptions
1. The behavior of both costs and revenues is
linear throughout the relevant range of the
activity index.
2. All costs can be classified as either variable or
fixed with reasonable accuracy.
3. Changes in activity are the only factors that
affect costs.
4. All units produced are sold.
5. When more than one type of product is sold,
total sales will be in a constant sales mix.
Contribution margin
Sales
Less: Variable cost
xx
xx
Contribution margin
xx
High-low method
Contribution margin ratio
Determine VC/unit
Contribution margin per unit / Unit selling
price = CMR
Change in total costs / High – low activity level =
VC/unit
FC = TFC – VC (x)
Break-even point
** however, it is not a precise measurement
because other activity levels are ignored in the
computation.
Total revenues = total costs (both FC and VC)
Break-even sales = variable costs + costs
BEP units = fixed costs / CM per unit
Five components of CVP analysis
1.
2.
3.
4.
5.
Volume or activity level
Unit selling price
Variable cost per unit
Total fixed costs
Sales mix
BEP peso = fixed costs / CM ratio
Margin of safety
Actual or expected sales – breakeven sales =
MOS peso
MOS peso / actual or expected sales = MOS
ratio
Sales for target net income
Job order costing
Characteristics and purposes of cost accounting


Variable costs + fixed costs + target net income
= required sales
Fixed costs + target net income / CMR =
required sales
Flow of costs in a job order cost accounting
system

Essential features of CVP income statement
CVP income statement classified costs
and expenses as variable or fixed costs and
specifically reports CM in the body of the
statement. It is also called the contribution
margin format and is for internal management
use only.
Absorption costing and variable costing

It parallels the physical flow of the
materials.
Manufacturing costs are assigned to the
work in process inventory.
2 major steps
1. Accumulating the manufacturing costs
incurred.
2. Assigning the accumulated costs to the
work done.
 In a job order cost system,
manufacturing costs are recorded in the
period in which they are incurred.
Nature and importance of a job cost sheet
Absorption costing
Variable costing
Product cost
Period cost
The perpetual inventory system is used.
The objective is to provide unit cost
information for product pricing, cost
control, inventory valuation and
financial statement presentation.

Fixed MOH
** Variable costing focuses on the purpose of
fixed mfg. costs which is to have productive
facilities available for sure.
** The use of variable costs is acceptable only
for internal use by management
** Defenders of absorption costing justify the
assignment of FMOH costs to inventory on the
basis that these costs are as much a cost of
getting a product ready for sale as DM and DL.

A job cost sheet is a form used to record
the costs chargeable to a specific job
and to determine the total and unit cost
of the completed job. Postings to job
cost sheets are made daily.
A separate job cost sheet is kept for
each job. Job cost sheets constitute the
subsidiary ledger for the Work in
Process Inventory account.
Predetermined overhead rate

It is established at the beginning of the
year.
Predetermined overhead rate = Estimated
annual overhead costs / Expected annual
operating activity
Activity base x predetermined overhead rate is
assigned to Work in Process and Jobs 1, 2, 3,
etc.
using the activity-based overhead rates
(cost per driver).
Activity cost pools used in ABC
Under and overapplied manufacturing overhead

Identify all resource-consuming
activities.
Activity cost drivers

Overapplied overhead – Understated NI,
Overstated COGS (unearned revenue, current
liability)
Underapplied overhead – Overstated NI,
Understated COGS (prepaid expense, current
asset)
Activity based costing
Traditional vs. ABC
The use of direct labor in traditional costing.
Steps in the development of an ABC system
1. Identify the major activities that pertain
to the manufacture of specific products
and allocate manufacturing overhead
costs to activity cost pools.
2. Identify the cost drivers that accurately
measure each activity’s contributions to
the finished product and compute the
activity-based overhead rate.
3. Assign manufacturing overhead costs
for each activity cost pool to products
To achieve accurate costing, a high
degree of correlation must exist
between the activity cost driver and the
actual consumption of the activity cost
pool.
Activity-based overhead rate = Estimated
overhead per activity / expected use of
cost drivers per activity

In assigning overhead costs, it is
necessary to know the expected use of
cost drivers for each product.
Benefits and limitations of ABC
Benefits of ABC
1. ABC results to more accurate product
costing because:
a. ABC leads to more cost pools;
relevant cost drivers are utilized.
b. ABC leads to enhanced control over
overhead costs.
c. ABC leads to better management
decisions.
Ultimately, ABC allows managers to understand
cost behavior and overall profitability.
Limitations of ABC
1. ABC can be expensive to use.
2. Some arbitrary allocations continue.
** however, not all activities labeled
nonvalue-added are totally wasteful, nor
can they be totally eliminated.
Value-added vs. Nonvalue-added activities
** Identifying and labelling activities as valueadded or nonvalue-added is part of the analysis
of operations, the first step, in an ABC system.

Hierarchy of activity levels to ABC
-
Activity-based management is an
extension of ABC from a product costing
system to a management function that
focuses on reducing costs and
improving processes and decision
making.
-
-
Value-added activities


Increase the worth of a product or
service to customers.
Involves resource usage and related
costs that customers are willing to pay
for.
JIT processing


Examples
1.
2.
3.
4.
5.
Engineering design
Machining
Assembly
Painting
Packaging
Non-value added activities

Production or service-related activities
that simply add cost to, or increase the
time spent on, a product or service
without increasing its market value.
Examples
1.
2.
3.
4.
5.
Repair of machines
Storage of inventory
Moving of materials
Maintenance
Inspections
Unit-level activities are performed for
each unit of production (Ex. Materials)
Batch-level activities are performed for
each batch of products (Ex. Setups)
Product-level activities are performed
in support of an entire product line (Ex.
Design)
Facility-level activities are required to
support or sustain an entire production
facility (Ex. Security)
JIT minimizes storage and waiting time,
which are nonvalue-added activities.
A primary objective of JIT is to eliminate
all manufacturing inventories by using
the pull approach.
3 important elements
1. Dependable suppliers.
2. Multi-skilled work force.
3. Total quality control system.
JIT
7 wastes
1.
2.
3.
4.
5.
6.
7.
Over production
Waiting
Transportation
Underutilization of employees
Inventory
Motion
Making defective products
Principles of JIT
1. Total quality management
- Seek long-term commitment
- Quality > cost
2.
3.
-
Minimize waste
Production Management
Pull system = made to order
Push system = made for inventory
Human Resource Management
Company-wide involvement
Diversified employees
Management support and
empowerment of workforce

RIP, FG
End less beg = ?
+ increase, - decrease
Process costing
Flow of costs
JIT accounting

Conversion cost
Production costs are accumulated with
inventory at later stages of the
production process. (JIT assumes that
small quantities of DM, WIP and FG will
be maintained)
Labor and overhead are normally
accumulated directly to COGS account.

Each unit receives the same amounts of
DM, DL and MOH costs.
Unit cost = total manufacturing costs / units
produced during the period
Equivalent units

Equivalent units of production measure
the work done during the period,
expressed in fully computed units.
Weighted-average method
Flow
RM purchased
xx
Add: RIP beg
xx
Less: RIP end
xx
Equals: Units completed xx
Add: FG beg
xx
Less: FG end
xx
Equals: Units sold
xx
EUP = Units completed and transferred out
(100%) + Equivalent units of ending WIP
(certain % only)

When materials are not added evenly
throughout the processing (ex. When all
materials are added at the beginning of
a process), WIP at the end of the period
will have different completion
percentages for materials and
conversion costs.
EUP – materials = Units completed and
transferred out - materials + Equivalent units
of ending WIP - materials (certain % only)
EUP – CC = Units completed and transferred
out CC + Equivalent units of ending WIP – CC
(certain % only)
4 steps to prepare a production cost report



Production cost reports provide a basis
for evaluating the productivity of a
department.
Companies often use a combination of a
process cost and job order cost system
called operations costing.
A cost-benefit tradeoff occurs as a
company decides which costing system
to use.


3 important cost concepts used
1. Relevant costs.
2. Opportunity cost.
3. Sunk costs.
Relevant costs in accepting an order at a special
price
Accept if: Incremental revenue > incremental
costs
-
When process-costing systems are appropriate
Basic concepts
Relevant costs
-
Steps in management’s decision-making process
1. Identify the problem and assign
responsibility.
2. Determine and evaluate the possible
courses of action.
3. Make a decision.
4. Review results of the decision.
** both financial and nonfinancial information
are considered.
Incremental analysis


The process used to identify the
financial data that change under
alternative courses of action.
In some cases, both costs and revenues
will change under alternative choices. In
other cases, only costs or revenues will
vary.
It is important to note that
Variable costs may not change under
the alternatives
Fixed costs may change
Incremental analysis involves the
determination of the probable effects
of decisions on future earnings.
It is assumed that sales in other markets
will not be affected by the special order.
If other sales were affected, the lost
sales would have to be considered in
making the decision.
If the units can be produced within
existing plant capacity, generally only
variable costs will be affected.
Relevant costs in a make-or-buy decision


Also referred to as an outsourcing
decision.
Opportunity costs should be
considered.
Decision rule in deciding whether to sell or
process materials further

Process further as long as the
incremental revenue from such
processing exceeds the incremental
processing costs.
Factors to be considered in retaining or
replacing equipment



Two factors to be considered:
manufacturing costs and the cost of the
new equipment.
The book value of the old machine is a
sunk cost.
Any trade-in allowance or cash disposal
value is relevant.
Fixed costs + variable costs = total budgeted
costs
Factors that are relevant in deciding whether to
eliminate an unprofitable segment


Often, fixed costs allocated to the
unprofitable segment must be absorbed
by the other segments. It is possible for
net income to decrease when an
unprofitable segment is eliminated.
Decision: choose the alternative which
results in the highest net income for the
company as a whole.
Sales mix and its effect on breakeven

Sales mix is the relative combination in
which a company’s products are sold.
Responsibility accounting
Features of responsibility reports for cost
centers


Responsibility accounting
Budgetary control


The use of budgets in controlling
operations.
Use of budget reports (actual results vs.
planned objectives).
** operating assets = current assets + plant
assets used in operations by the center (beg +
ending cost or book values of the assets)

Usefulness of static budget reports


A static budget is a projection of budget
data at one level of activity.
Budget > actual = unfavorable
Development of flexible budgets and the
usefulness of flexible budget reports


A flexible budget projects data for
various levels of activity.
The flexible budget is a series of static
budgets at different levels of activity.
Controllable margin is considered to be
the best measure of the manager’s
performance in controlling revenues
and costs.
Investment center, ROI = Investment
center controllable margin (Php) /
Average investment center operating
assets

A manager can improve ROI by:
a. Increasing controllable margin,
and/or
b. Reducing average operating assets
Controllable margin can be increased
by:
a. Increasing sales
b. Reducing variable and controllable
fixed costs